The Non Commercial Losses Rules and Prior Year Tax Losses

Introduction

The Non-Commercial Loss (NCL) rules have been a thorn in the side for individuals conducting a business, alone or in partnership, since their inception in 2000.

If you fail to satisfy these rules, any tax loss from the relevant business activity incurred is deferred and carried forward until the tests are satisfied in a subsequent tax year (if ever), even where your activity meets the criteria to be an income tax ‘business’. This is a real frustration to taxpayers wanting immediate tax relief for the losses they derive in the early years of their activity.

We deal regularly with these rules at Baumgartners given the number of horse breeders we act for, as their activities often take beyond three years to derive a profit.

This article discusses one of the common ‘problem’ areas we often advise horse breeders on, being how to determine what is Adjusted Taxable Income (‘ATI’)and more specifically - how carry-forward revenue losses impact the ATI calculation.

Overview

The NCL rules, found at Division 35 of the Income Tax Assessment Act 1997 (ITAA 1997), prevent losses from a non-commercial business activity carried out by an individual taxpayer (alone or in partnership) being offset against other assessable income in the year in which the loss is incurred, unless an exception applies.

Losses that cannot be offset against other income in the year in which they arise (i.e. quarantined losses) may be carried forward to a future year to be offset against profit from the non-commercial activity or other income (if a relevant exception from Div 35 is available in that year).

NCL - The Exemptions

The exceptions to the rules are:

1. The individual’s relevant business meets at least one of four tests and, for 2009-10 and later income years, their ATI does not exceed $250,000.

2. If the exception described in (1) is not available, the Commissioner of Taxation may, based on a Private Ruling requested in the approved form, exercise their discretion not to apply the loss deferral rule if its application would be unreasonable.

3. The individual is carrying on a primary production business or a professional arts business and the income from other sources (excluding net capital gains) is less than $40,000.

4. The NCL rules do not apply if the individual’s activities do not constitute a business (e.g., the activity is a hobby, the income is from passive investments such as a negatively geared property or other investment, or where a business has ceased).

Exception 1 - The Four Tests

As mentioned above, an individual can only deduct a loss from a non-commercial activity if they meet at least one of four tests and from the 2009–10 income year their ATI is less than $250,000. The four tests are:

Assessable Income Test— the assessable income (including capital gains) for that year from the activity must be at least $20,000;

Profits Test— the activity must have resulted in taxable income in at least 3 out of the last 5 income years, including the current year;

Real Property Test— the total reduced cost base of real property or interests in real property used on a continuing basis in carrying on the activity must be at least$500,000,

Other Assets Test— the total value of other assets (other than motor vehicles) used on a continuing basis in the activity must be at least $100,000.

Adjusted Taxable Income (ATI)

The ATI definition is often misunderstood however is central to the application of the NCL rules. An individual passes the income threshold test in an income year if the sum of the following, being ATI, is less than $250,000:

a) Taxable Income

b) Reportable Fringe Benefits total  

c) Reportable Superannuation Contributions, and

d) total net investment loss for the income year (e.g. net loss on share investments, rental loss etc)

Carry-Forward Losses and Taxable Income

Taxable income is one component of ATI and easily the most important.  Taxable income is calculated as:

Taxable Income = Assessable Income − Allowable Deductions

The problem often encountered is that tax losses incurred and carried-forward from a prior year, are overlooked as an ‘allowable deduction’ for the purpose of the taxable income definition resulting in a fundamental mistake in application of the NCL rules.

Tax losses are incurred where the sum of a taxpayer’s allowable deductions exceed their assessable income and should not be confused with the abovementioned deferred loss incurred where your business loss meets none of the NCL tests and must be carried forward under those rules only.

An ATO private ruling, issued in October 2015 and referred to as number “1012896499113” confirms that carried-forward revenue losses do form part of ‘taxable income” for the purposes of applying the NCL rules.

Applying a carried-forward revenue loss can make it easier to meet the NCL tests as their deduction can reduce ATI below $250,000. Consider this example:

Example – Carry Forward Losses keep ATI under $250,000

Glenn runs a horse breeding businessthat incurred a taxation loss of $150,000 in the 2025 financial year. Sales for2025 were $30,000, lower than normal due to a virus that swept through hisproperty.

Glenn must satisfy the NCL tests to beable to claim the losses against his other income in the 2025 year.

His other income and deductions in 2025were:

1.     Wages - $300,000

2.     Net Rental loss  – $60,000

3.     Work Related Deductions - $15,000

4.     Carried Forward Revenue loss from 2024- $40,000

Glenn’s ATI for 2025 is calculated as:

ATI = $300,000 (Wages) less $15,000 (Work Related Deductions) less $40,000 (Carried Forward Revenue Losses)

ATI = $245,000

As his ATI is under $250,000, Glenn need only meet one of the four tests to claim his $150,000 horse loss.  Glenn’s sales turnover was $30,000; therefore he can claim the loss as he meets the Assessable Income Test.

The important feature of this calculation is that the $40,000 carried forward revenue loss is allowed for the purpose of calculating ATI (however the net rental loss of $60,000 is not allowed as its amount is added back for ATI purposes).

If not for the availability the revenue losses, Glenn would have need to satisfy one of the more onerous tests or would have been required to apply for a Private Ruling in order to deduct the $150,000 loss.

Please do not hesitate to contact the writer if you wish for me to clarify or expand on any of the matters raised in this article.

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